NH Legal Perspective: Equity compensation for startups: Attracting and retaining talent

Stock options

Stock options are the most common form of equity-based compensation for startups. An option is a contractual right to purchase equity at a fixed price during a specified period of time in the future. As the value of the equity increases, the employee’s option to purchase the equity is locked in at the value of the equity on the date the option is granted. Typically, options are subject to vesting, which incentivizes the employee to stay with the company until the option is fully vested. Until the option is exercised, the recipient of a stock option has no rights as a shareholder.

Generally speaking, employees are eligible for incentive stock options (ISOs); however, a number of requirements must be satisfied under the Internal Revenue Code (the Code) in order to take advantage of the favorable tax treatment that ISOs provide. For example, the option’s exercise price cannot be less than fair market value when it is granted, which could require the company to obtain a valuation. If the necessary requirements are met, the employee would not owe any tax until the option is exercised and the stock is sold, and then the difference between the exercise price and the sale price may be taxed as capital gains.

Restricted stock

Another popular form of equity compensation is the grant or sale of restricted stock, which is typically subject to vesting and transfer restrictions. Additionally, the company usually has the option to repurchase the stock under certain circumstances, including termination of employment. Unlike with options, the employee would actually have an ownership stake in the company and may have voting rights.

Restricted stock is most commonly granted shortly following the company’s formation, while the value of the stock is nominal. Section 83(b) of the Code allows the recipient to pay income tax on the fair market value of the shares at the time of grant (when the stock presumably has nominal value), as opposed to when the shares are fully vested and likely worth more. In order to take advantage of this option, the recipient must file an 83(b) election within 30 days after the stock is granted. As the fair market value of the company’s stock increases, the tax impact can create an impediment to a company’s ability to grant restricted stock to employees, as employees often do not have the cash to pay a significant tax bill on the shares of an illiquid, early-stage company that remain subject to vesting.

Phantom stock and stock appreciation rights

As an alternative to issuing actual equity, startups can grant phantom stock, which affords employees with certain benefits of stock ownership. Phantom stock provides a contractual right to receive a cash bonus upon the occurrence of certain triggering events (such as the sale or change of control of the company), and the bonus is equivalent to what the employee would have received if they actually held stock in the company. The phantom stock interest typically terminates if the employee leaves or otherwise stops providing services before a triggering event occurs.

The recipient of phantom stock does not owe any taxes unless a bonus is actually paid out, at which point income tax is paid on the amount received. Stock appreciation rights (SARs) are similar to phantom stock, but this incentive is structured so that the employee only gets the value of any increase in the equity’s value, starting on the date the incentive is granted, as opposed to receiving the full value of the underlying equity as well as any appreciation.

Profits interests (for LLCs)

For startups structured as limited liability companies (LLCs) taxed as partnerships, profits interests can be an effective alternative to traditional stock-based incentives. A profits interest entitles the recipient to share in the company’s future profits and appreciation but not in the existing capital at the time of grant. If the LLC was liquidated immediately after the interest was granted, the recipient would not be entitled to a share of the LLC’s assets.

From a tax perspective, properly structured profits interests can be granted without creating immediate taxable income for the recipient, since the award has no current value when granted. As long as the profits interest is held for at least one year and other conditions are met, then any appreciation in value upon sale or redemption is generally taxed at favorable capital gains rates.

Once an individual holds a profits interest, the individual is treated as a partner and member instead of an employee. As a member of the company, the individual would also need to sign the company’s operating agreement. That change in status may not be favorable for the employee or preferable for the company, so these consequences should be considered carefully as alternatives are weighed.

Choosing the right form of equity compensation is not just a legal or tax decision — it is a strategic move that can have a significant impact on a startup’s growth, value, and ability to compete for and retain talent. Stock options, restricted stock, phantom equity and profits interests are all equity-based compensation alternatives that can be considered, though the best choice will ultimately depend on the company’s structure, stage and long-term vision. For startups looking to conserve limited cash (and founders aiming to retain control of their company) while attracting and retaining key talent, the right equity plan can conserve funds while building a group of stakeholders that are committed to the company’s growth.